Debate might give new life to mortgage cramdown legislation

If there is a term that strikes fear in the hearts of residential lenders everywhere, it is “cramdown.”

Lenders dread the judicial procedure that erases a portion of a borrower’s mortgage because the house, which is the underlying security or collateral for the loan, is worth less than what is owed on it.

Actually, the word is a euphemism for forcing a ruling upon a creditor, as in “crammed down” the lender’s throat.

The proper term is “bifurcation,” meaning that in a bankruptcy proceeding the loan is split into a secured claim equal to the current appraised value of the property and an unsecured claim equal to the difference between the unpaid balance and the home’s present value. Generally, the borrower is required to continue to pay on the secured portion, while the difference is treated like any other unsecured debt.

But whatever you call the concept, mortgage companies hate it even more than workouts or loan modifications.

At least they get to control the process in a typical loan mod. But with a cramdown, they are at the mercy of a judge who may more likely favor a down-and-out borrower over a big-time corporation.

That’s the way lenders tend to look at cramdowns, anyway.

Because borrowers would still be liable for an amount equal to what their places are now worth on the open market, the lenders would receive what they would have had the homes foreclosed — and maybe more. So what’s the big deal?

A research paper from two economists at the Federal Reserve Bank of Cleveland contends that if what happened during the agricultural lending crisis of the 1980s is any indication, the actual negative effect of cramdowns is only minor.

Back then, farming was going full-bore and the average price of farmland nationally was rising rapidly. Then the bottom fell out, and many farmers who had borrowed heavily to acquire additional acreage found themselves owing more to their mortgage companies than their properties were worth.

The story sounds familiar. “Farm loan-underwriting standards eased, and a speculative lending boom ensued. Lenders began to rely less heavily on the ability of borrowers to service their debt from operating cash flows, and more on the continued appreciation of the underlying collateral — the farmland — for repayment,” says the study by Thomas Fitzpatrick and James Thomson.

“But when demand for farm goods began to fall, farm real estate prices also fell precipitously. As farmers’ cash flows decreased … many farmers saw their interest rates increase and found that they could not make payments and were underwater on their mortgages.”

Like many troubled homeowners now, some financially strapped farmers in the early 1980s found themselves in danger of losing their primary residences with little prospect for relief under bankruptcy options available at the time. So Congress enacted legislation establishing Chapter 12 of the Bankruptcy Code, which allows judges to reduce — in what was then called a stripdown.— the debt that farmers owed on their homes.

But the effect was not nearly as dire as the banking community had told lawmakers it would be, the Cleveland Fed economists say. Chapter 12 “did not change the cost and availability of farm credit dramatically,” they explain.

That’s not what residential lenders are telling Congress these days whenever the discussion turns to allowing judges the authority to independently modify mortgages on all principal residences to their current value. (Mortgages on commercial properties, second homes and vacation homes already can be judicially modified.)

The Mortgage Bankers Assn., for example, says giving judges “free rein to rewrite loan contracts without economic restraint” would drive up the cost of financing for future borrowers by as much as 2 full percentage points.

Because lenders and mortgage investors would no longer be certain their loans would be truly secure, the MBA contends, they would be forced to require larger down payments and charge higher interest rates. “At a time when the mortgage market is experiencing a serious credit crunch, [cramdowns] will increase costs to consumers, further destabilize the mortgage market and hurt the overall economy,” the MBA claims.

But economists Fitzpatrick and Thomson also note that “what was most interesting about Chapter 12 is that it worked without working.” That is, rather than inducing a flood of bankruptcy filings, the simple prospect of a judge’s unilaterally changing the terms of their loans led many farm lenders to institute loan modifications of their own volition.

Not so, counters John Blanchfield, senior vice president at the American Bankers Assn., who takes exception to many of Fitzpatrick and Thomson’s findings.

Not only is the “attempt to use the Chapter 12 experience as a road map to solve the current mortgage crisis based on a limited and flawed retelling of history,” wrote the director of the ABA Center for Agriculture and Rural Banking in a letter last month to the two economists; it was destructive to banks and harmed farmers “who needed credit after it was enacted.”

What is perhaps most interesting about this debate is that Congress is not currently considering cramdown legislation. But maybe the discussion will bring the concept back to life. After all, the Obama administration backs bankruptcy reform, and major lender Citigroup and consumer groups have said they are on board.

Various bills are in the hopper, most notably a perennial one by Sen. Richard J. Durbin (D-Ill.), who chairs the Appropriation Committee’s financial services and general government subcommittee, and the House last year passed cramdown legislation, 234 to 199.

The Senate, however, has shown little interest in the measure, and when the Wall Street reform bill offered cramdown language in the summer, the House soundly rejected it. But stay tuned. You never know when cramdowns will resurface again.